Friday, September 30, 2011

Our instinct is to select a forecast as our own, and then defend it. This can be a disastrous investment strategy.

Longtime correspondent R.S.D. recently suggested I update the 5-year scenario I laid out on February 15, A 5-Year Scenario: 2011-2016. That is an excellent suggestion and I will attempt to do so. But first we need to examine the intrinsic risks of forecasting.

I have no idea if the predictions in that entry qualify as accurate or not, but we are still in the first inning of the first phase, and predicting the outcome of the 9th inning, much less the game, is impossible.

I am much less confident of forecasts and predictions than most of my blogging peers or the Wall Street analysts who churn out reams of analyses daily or weekly, little of which proves either accurate or useful in terms of dodging losses and downturns.

I have no more faith in my own forecasts as anyone else's, and this reflects my belief that history rarely follows the expected paths. As I have often noted here and in my new book, An Unconventional Guide to Investing in Troubled Times humans are wired to feel uncomfortable with uncertainty and contingency, and so we gravitate to a position after a short time even if we have no new information.

Once we have (often unconsciously) defaulted to a position that aligns with our ideological leanings, then we are wired to cling to it, a predisposition that is visible in confirmation bias, our tendency to select data which confirms our pre-selected position.

Clearly, these two traits of the human mind are potentially disastrous for investors. There are lots of explanations out there for why so few people actually beat the market over both bull and bear markets-- numerous studies have found the actual number is essentially statistical noise--we might start with these two traits: extreme discomfort with uncertainty and indecision, and a powerful urge to defend rather than abandon a position once taken.

Readers of this blog know that I truly have no alignment with either "Liberal" or "Conservative" political ideologies, for the obvious reason that "liberal" and "conservative" are merely marketing terms designed to distract us from the fact that both parties are beholden/captured by the same Plutocracy/Oligarchy of Central State fiefdoms and crony/cartel Capitalism concentrations of wealth.

Despite the painful obviousness of this fact, the vast majority of Americans still cling to one ideology or the other, as if the travesty of a mockery of a sham "parties" have any value or "solutions" other than bamboozling citizens into looking the other way as they go about their job of funneling the plunder and power to various Elites and cartels.

In a similar fashion, the vast majority of investors seek the psychological safe haven of one forecast or another: hyper-inflation, deflation, stagflation, biflation, sideways markets, you name it. Our desire to nail down a forecast which will guide our investment decisions is entirely natural, as is our vociferous defense of that position once we have embraced it.

I have poked around all these basic forecasts for six years, and have always ended up dissatisfied with all of them, even as I have described the compelling features of various positions. Proponents of each position, however, brook no dissent with their chosen forecast, and any doubters are quickly attacked as heretics.

I have described this quasi-religious devotion to one position or another many times, and have often referred to Keynesianism and the Fed as cargo cults based on nonsensical belief systems which ultimately distill down to magical incantations such as "animal spirits" or "don't fight the Fed."

Anyone who remains unattached to one forecast or another is like the blindfolded heretic in a circular firing squad: after the bullets fly, the heretic finds himself unharmed while the circular firing squad eliminated itself.

In writing my book this year, I finally came to understand the consequences of this overwhelming drive within us to latch onto one forecast or another. If we combine this understanding with a grasp of complex non-linear systems, and how they can destabilize or enter a chaotic phase shift when parameters are changed, then we philosophically become more attuned to a state of permanent contingency, in which all forecasts are viewed as thought experiments rather than ideologies.

The human mind rebels against an embrace of permanent contingency on two fronts, internally and externally. Internally, we tire of indecision and uncertainty, and externally, we feel a great need to defend our position by attacking heretics and disbelievers. Each forecast is defended by what amounts to an Inquisition, because unbelievers and heretics threaten all forecasting cults with doubt: what if my chosen position is wrong?

That possibility is more fearful to the human mind than losing money. Thus we see one camp after another ground up by market gyrations which they have zealously claimed are impossible, or even "proven" are impossible, even as events have overtaken their forecast.

In the middle of an uptrend, then extending that uptrend to the sky becomes not just plausible but even "likely," hence the calls for Apple to become the first $1,000 per share company, the glowing forecasts for Netflix's permanent growth, and so on.

Favored explanations of busted forecasts and failure of various cargo cults include manipulation (a real force, to be sure, but also an all-too-handy scapegoat for being wrong) and market instability. very rarely does one hear "my forecast was wrong, I'm changing it." Why? There is also an element of human pride at work. We are all ready to describe our brilliant 10-bagger trade, but circumspect about our losses.

As I note in my new book, if you double your investment with each trade (not that difficult with options or futures contracts), it only takes 11 trades (or 18 hedged trades) to turn $500 into $1,000,000 (see page 63). If a forecast was highly accurate, how difficult would it be to align 11 good trades in a row? The reality is that very few traders turn $500 into $1,000,000, and if they accomplished that, then they could go on with their forecast/system and turn the $1 million into $500 million, and so on. (Note: the larger the position, the more difficult it is to find opportunities of sufficient size and liquidity. Thus the "hot" manager tends to become less hot once the fund grows to the $1 billion and above in size.)

All of this is to say that any "forecast" I might make here is only a thought experiment which takes certain dynamics of a highly complex non-linear system and ponders the probabilities of how they might interact.

A thought experiment can be dropped or revised if it is inaccurate or misleading, but an ideologically based forecast must be defended against all doubters and heretics. That's why it's important to make the distinction between the two: a thought experiment is founded on adaptability, flexibility, contingency and skepticism, all the traits which I expect will continue to have value regardless of how the next decade plays out.

I tend to rely more on charts than on ideology, as the charts are reflections of behavior not belief. Thus I have continued to describe the possibility that the U.S. dollar would gain (as reflected in the DXY index) since April/May. Simply discussing this possibility led me to be vilified as a "danger" to my readers. ("Heretical" thought is intrinsically "dangerous" to orthodoxies of all stripes and flavors.)

This possibility has taken months to play out, and it is still playing out in an unpredictable fashion. Nobody knows how high the DXY might go in the next four months, much less the next four years. All we can say with some certainty is the idea that the DXY might rise in a sustained fashion is generally disbelieved as "possible," and the notion has more skeptics than believers.

All of this is necessary preface to any updating of the February 2011 "forecast," for everything is contingent and subject to change. The more system dynamics are repressed, the more likely it becomes that "improbable" events occur and "highly probable" trends dissolve or reverse. That's the world we live in: the Status Quo forces are attempting to control and suppress dynamics beyond the control of policy and intervention. Their intervention and perception management simply raise the probabilities of "improbable" events occurring.

That's another good reason to keep a light touch on the "forecast" button.

Thursday, September 29, 2011

The entitlement mindset includes much more than government benefits programs.

The word entitlement commonly refers to government benefits to which we are entitled as taxpayers and/or citizens/residents. But there are layers of entitlement in the American psyche far beyond government benefits programs.

Let's start with the government benefits entitlements. The programs most people refer to as entitlements are Social Security and Medicare, which taxpayers pay for with payroll taxes (even if the money just goes into one giant Federal pot).

Beyond these "I paid into them" entitlements are the "welfare" entitlements of Medicaid, Section 8 Housing, SNAP/food stamps, etc., which are paid out of general tax revenues and which are available to anyone who qualifies, regardless of their status as taxpayers.

Buried within Social Security is another large entitlement program for the disabled and dependents (widows and orphans).

Veterans are entitled to benefits as a result of their military service, as are their families.

Employers pay for other employment-related entitlements: Federal and state unemployment, workers compensation and disability insurance, etc.

The entitlement mindset is thus firmly established in the American psyche. If we experience bad luck and/or the negative consequences of poor choices, we have been trained to expect the government at some level to alleviate our suffering, cut us a check or otherwise address our difficulties.

The poisonous problem with the entitlement mindset is intrinsic to human nature:once we "deserve" something, then our minds fill with resentment and greed, and we focus obsessively on creating multiple rationalizations for why we "deserve our fair share."

Eventually this leads to a government that has been reduced to a competitive stripmining operation in which the spoils are divided up amongst the most politically powerful Elites: in other words, the government we now have.

The entitlement mindset atrophies self-reliance, adaptability and flexibility, all key survival traits. If the government will "fix" our health, we no longer feel responsible in the way one does if there is limited government/employer-provided healthcare. If we expect our Social Security retirement regardless of what other conditions may be affecting the global economy or our nation, then we stop being responsible for managing our financial affairs in the same way as one does when there is no "guaranteed" retirement entitlement.

The question isn't whether entitlements are a "right" or not, the question is their sustainability now that the demographic, financial and energy foundations of those promises has eroded. Clearly, the government has a role in providing for public health and safety, but to claim that entitling every citizen to hundreds of thousands of dollars in healthcare is "public health" spending is absurd.

Based on projections of high-birthrates/cheap-oil/high-growth in the 1940s - 1960s, entitlement programs were promised basically forever, with no recognition that conditions might change. Now conditions have changed, demographically, financially and in terms of energy input costs.

We might usefully think of the government as a ship in a sea governed by forces too planetary to influence: the tides, currents, winds, etc. Entitlements are essentially a claim that the small ship of government "should" be able to bend the sea to its will, regardless of what tidal forces, winds and currents are at work.

we can claim it's our "right" not to sink, but gravity and the ocean do not respond to our claims of permanent "rights."

But these direct government entitlements only scratch the surface of our sense of entitlement. We don't just expect healthcare and retirement; if we're honest with ourselves, don't we also expect these other entitlements?

1. Cheap and abundant fuels and energy. We can debate whether this constitutes an implicit "right" or an entitlement, but the point is that Americans expect unlimited fuels and energy at low cost, and if cheap, abundant energy vanishes then they will demand "somebody make this right," with the "somebody" presumably in government and certainly not the individual American or his community.

2. Ever-more government services and benefits, i.e. the entitlement mindset knows no bounds.

3. Full employment and bountiful employment opportunities. If we can't find a job or create value that someone is willing to pay/trade for, then the government should create jobs out of thin air.

There are only two ways to fund "make-work" jobs: either take more money from existing wage-earners via taxes and redistribute the funds to potentially unproductive uses, or print/borrow the money into existence. Both have costs in terms of the productivity surplus of the entire nation and in the potential to destabilize the financial foundation of the economy.

4. An education suited to the demands of a global economy, etc., as opposed to providing the basic skills of learning, so the citizens can educate themselves throughout life. This distinction is lost in the endless debates over education, but in fast-changing environments and times, the only real value of any education is to learn how to learn. Though it seems "impossible" to the Status Quo educator, the world we are preparing students for--one dependent on consumer spending, cheap oil, globalization, ever-expanding government and healthcare costs, exponentially increasing debt to pay for everything, etc.--may not exist in 5 or 10 years.

5. An upper-middle class lifestyle for everyone who does what the Status Quo expects: get a graduate-level university degree, sacrifice for the corporation, remain politically silent/passive, etc. The idea that toeing the line will not result in a big-bucks secure profession/career is somehow a violation of the social/financial contract of Corporate America--once again, a right or an entitlement that is implicit in the American psyche.

6. Cheap and plentiful food. Once again, if food costs actually rose to "percentage of income spent on food" levels found in developing-world nations, Americans would undoubtedly demand that the "government do something." Once again, this is like demanding the ship's crew change the winds and tides. As oil prices rise, food costs will rise. There is no way out of this, as the primary input of agricultural costs is oil and petroleum-based fertilizers, chemicals, transport, etc. extremes of weather can ruin crops regardless of policy.

7. That the U.S. should be able to influence other nations to act in what we perceive as our best interests. The idea that we cannot persuade/force others to do what benefits us is anathema to the general entitlement mindset, e.g. "what's our oil doing under their sand?"

There are undoubtedly many more layers of implicit entitlements, and the analogy that comes to mind is a worm-riddled, leaky wooden-hulled sailing ship approaching a coral reef. The only way into the relative calm of the lagoon beyond is to lighten the ship enough to pass over the reef, or the sand bar on the other side of the lagoon.

If the ship sails on fully loaded with the heavy baggage of the entitlement mindset, the reef will either rip out its bottom or the ship will be wedged on the sand bar, where the waves will break it apart.

In other words, the destruction of the ship is guaranteed in either scenario. The only possible way to save the ship and its passengers/crew is to throw most of the inessential baggage overboard. Everything that the passengers "can't live without" will doom them if it isn't jettisoned, and soon. Once the hull has been shredded by the coral reef, or the hull is stuck on the sand bar, it will be too late: jettisoning all the financial "rights," entitlements and "essentials" will not save the ship or its crew/passengers.

The entitlement mindset is heavy baggage indeed, and the emotional content of the baggage-- resentment, anger, and a debilitating focus on "what I deserve"--is toxic to the traits we will need in abundance to weather the decade ahead: flexibility, adaptability, open-mindedness, experimentation, community and self-reliance.

Monday, September 26, 2011

Technical traders don't pay attention to explanations of what should happen or is not possible; they just look at the action of price and indicators.

For the past several years, the dominant view of the U.S. dollar has been that a sustained rise in the dollar is not possible. This offers a good example of the difference between "fundamental" explanations and predictions of financial trends, and the technical perspective.

Fundamental explanations and predictions have an awkward tendency to claim something that has already happened is impossible.

Technical traders avoid fundamental explanations about why some trend or another is impossible or inevitable. These explanations tend to be highly appealing ideologically, but ideology of any flavor generally makes a poor foundation for making productive trades.

With that preface, let's look at a weekly chart of the long-loathed U.S. dollar:

While there are compelling fundamental explanations of why the U.D. dollar is doomed in the long run, making money in the present via predicting what might happen in future years is intrinsically problematic because nobody knows what will happen in the future, or when. Traders can only make money by assessing the probabilities of near-term price movement based on price and reflections of price movement, i.e. indicators.

For example, if you call up a long-term chart of the Dow Jones Industrial Average (DJIA), you will note that the 20-week moving average fell below the 50-week moving average (MA) in February 2008. This bearish cross presaged the meltdown that ensued later that year.

Now we see the exact same cross occurring in September 2011. Coincidence? Possibly. After all, isn't the DJIA up big today?

In a similar fashion, the 50-day MA is about to make a bullish cross up through the 200-day MA on the DXY (dollar index). A sign of strength? If an investor's ideology demands a bearish intepretation to all data regarding the dollar, then anything that runs counter to that ideology must be rejected.

On this weekly chart of the DXY, we observe price has broken a long downtrend, and that it has risen above the 50-week MA and is now testing strong resistance at the 200-week MA. By happenstance (or not), the DJIA is struggling to stay above its 200-week MA at 10,730.

In the past, when the DXY broke above the 200-week MA, a powerful uptrend developed.

Interestingly, skepticism is the ideal background for a sustained rally because skeptics resist buying in, creating a large pool of potential future buyers.

Is a sustained uptrend in the U.S. dollar possible or impossible? Technically, nobody can say. All a technical trader can assess is what looks more or less probable near-term, given past technical signals and price action.

Saturday, September 24, 2011

Modern economics is analogous to the junk-science of 17th century medicine, and it serves a symbolic economy of phantom wealth and freedom.

Back in the bad old days, the premier physicians of the age accepted and practiced the idea that the cure for illness was to bleed very ill patients, effectively weakening them. Countless patients who might have recovered if simply left "untreated" died as a result of the misguided "science of healing" of the era.

Only with the advent of a true understanding of the nature of infection, the immune system and disease did the "folk" pseudo-science of bleeding pass from accepted medical practice.

We are mired in a similar era of pseudo-science being accepted as actual science, i.e. as reflecting the underlying causal mechanisms of life and the universe, and that pseudo-science is called economics.

As I have noted here many times, we are experiencing not just a standard-issue financial crisis but the failure of the entire pseudo-science edifice of modern conventional economics.

The basis of pseudo-science is to mask unfounded, misguided and potentially disastrously dangerous ideas drawn from superstition and folk beliefs with the external trappings of real science. Thus economics presents itself as a "science" by invoking the symbolic magic of equations and quantification of data gathered from the real world.

In esence, the "understanding" of junk-science is symbolic: the body is plagued with "humors" which can be drawn out via bleeding the patient, etc. The actual workings of the body, far beyond the conceptual reach of the folk/junk symbolic "science," are conceptualized symbolically via analogies: disease is "hot" or "cold," the body functions like a clock, etc.

In the exact same fashion, conventional economics "understands" the workings of the economy symbolically, and its "cures" play out in its artificial construct, thesymbolic economy.

The symbolic economy is based on the cargo cult of "animal spirits", the magical "humors" which ignite the economic activity quantified by the pseudo-science. The witch-doctors at the Federal Reserve (the eminent, highly educated "expert" bleeders) have been busy painting radio dials on rocks for the past four years, hoping that their increasingly desperate pleas will magically reach the gods of "animal spirits."

The true nature of conventional economic's symbolic economy is best illuminated by the cargo cult's increasing dependence on managing perceptions as the "tool" to influence financial behavior. In other words, the "physicians" rely on fundamentally symbolic actions to influence the symbolic economy.

One of the folk beliefs of the cargo cult priesthood is that ruthless pursuit of self-interest to the point of worshipping self-serving pathology is the foundation of a "healthy economy." The end-state of such a quasi-religious faith is of course the purchase of the machinery of governance to the point that government at all levels is reduced to a battle between self-serving concentrations of wealth.

The cargo cult priesthood's primary goal is to preserve the symbolic wealthcreated by the symbolic economy. One way to understand symbolic wealth is that it isphantom wealth created in symbolic form.

Simply put, no economy can consume more than it generates in real surplus. Rather than face up to this constraint, the Fed creates phantom financial wealth which ends up in the hands of politically influential concentrations of wealth--in essence, a self-referential cycle of creating phantom wealth to serve the interests of current holders of phantom wealth.

There is another layer to the symbolic economy: carefully manicured totems of a vanished free market and independent government are maintained by the Status Quo that benefits from the artifice. The useful fiction that the economy is still a "free market" is heavily promoted by the Status Quo Media, and rags-to-riches stories are trumpeted ceaselessly as "proof" of the free market.

All this marketing gins up symbolisms that mask the actual mechanisms of the economy. This systemic official lip-service is also paid in China, where various useful fictions are fashioned into a symbolic economy: that the one-party rule of a command economy nurtures a true but limited form of free-market capitalism in which it is glorious to get rich.

This masks the reality of a systemic crony-capitalism married to a sclerotic command economy.

Thursday, September 22, 2011

Yesterday I described three fatal flaws in the Eurozone; today we look at three more structural reasons the zone and its common currency the euro are doomed.

I have accepted an invitation to join ChrisMartenson.com as a contributing editor. I am honored by the invitation from Chris and Adam, and will be contributing in-depth analyses once or twice a month. Today's post is a reprint of my first article, The Fatal Flaws in the Eurozone and What They Mean To You.

As most of you know, the Web is only free to users; creating and hosting original content is not free. There are few ways for those of us who create the original content to be compensated, and one is a subscription/paywall model. As a result, the actionable elements of my analyses will be available exclusively to enrolled members of ChrisMartenson.com. Most of you are familiar with this model, as many sites (iTulip, for example) use it as a means of supporting the costs of providing original content.

Chris Martenson.com provides a wealth of information for free, and oftwominds.com will continue to be free. As the traffic has grown, the costs of hosting this site have skyrocketed (dedicated servers are not free). My goal is to provide value to both visitors and enrolled members; the free portion of my contributions will be cross-posted here on oftwominds.com.

Your readership and support are greatly appreciated.

On a side-note: the long dollar trade that I have presented here since May appears to be playing out as the charts suggested.

Reason #1:: The Imbalance between Exporting and Importing Nations

An intrinsic source of instability is the imbalance between export powerhouse Germany, which generates huge trade surpluses, and its trading partners in the EU that run large trade and budget deficits— Portugal, Italy, Ireland, Greece, and Spain.

Those outside of Europe may be surprised to learn that Germany's exports are roughly equal to that of China ($1.2 trillion) even though Germany's population of 82 million is a mere 6% of China's 1.3 billion. (Germany and China are the world's top exporter nations, while the U.S. trails as a distant third.)

Germany's emphasis on exports places it in the so-called mercantilist camp, which depends on exports for their growth and profits. Since the inception of the euro, Germany's exports rose an astonishing 65% from 2000 to 2008 while its domestic demand was near zero. Without strong export growth, Germany's economy would have been at a standstill. The Netherlands, which reaped a $33 billion trade surplus from a population of only 16 million residents, is another example of a Eurozone country which runs substantial trade surpluses.

The "consumer" countries, on the other hand, run large current account (trade) deficits and large government deficits. Italy, for instance, has a $55 billion trade deficit and a budget deficit of about $110 billion. Total public debt is a whopping 115.2% of GDP.

Spain, with about half the population of Germany, has a $69 billion annual trade deficit and a staggering $151 billion budget deficit; fully 23% of the government's budget is borrowed.

Though German wages are generous, the German government, industry and labor unions kept a lid on production costs even as exports leaped. As a result, the cost of labor per unit of output—the wages required to produce a widget—rose a mere 5.8% in Germany in the 2000-2009 period, while equivalent costs in Ireland, Greece, Spain, and Italy rose by roughly 30%.

The consequences of these asymmetries in productivity, debt, and deficit spending within the Eurozone are subtle. In effect, the euro gave mercantilist, efficient Germany a structural competitive advantage by locking the importing nations into a currency, making German goods cheaper than domestically produced goods.

Put another way, by holding down production costs and becoming more efficient than their Eurozone neighbors, Germany engineered a de facto devaluation of its own products within the Eurozone at the expense of its importing neighbors.

Reason #2: The Euro Removed the Mechanism of Currency Devaluation

The euro had another deceptively pernicious consequence. The overall strength of the currency enabled debtor nations to rapidly expand their borrowing at low rates of interest. In effect, the euro masked the internal weaknesses of debtor nations running unsustainable deficits and those whose economies had become precariously dependent on the bubble in housing (Ireland and Spain) for growth and taxes.

Prior to the advent of the euro, when overconsumption and over-borrowing began hindering an importing, "consumer" economy, the imbalance was corrected by an adjustment in the value of each nation's currency. This currency devaluation would restore the supply-demand and credit/debt balances between mercantilist and consumer nations.

For instance, the Greek drachma would fall in value versus the German mark, effectively raising the cost of German goods to Greeks, who would then buy less German products. The trade deficit would shrink, and lenders would demand higher rates for Greek government bonds, effectively pressuring the government to reduce its borrowing and deficit spending.

But now, with all 17 nations locked into a single currency, devaluing currencies to enable a new equilibrium is impossible. As a result, Germany is faced with the unenviable task of bailing out its "customer nations.” Meanwhile, the residents of Greece, Italy, Spain, Portugal, and Ireland are faced with the unenviable task of cutting government benefits to realign their budgets with the productivity of their underlying national economies.

Germany helped enable the over-borrowing of its profligate neighbors by buying their government bonds; according to BusinessWeek, German banks are on the hook for almost $250 billion in the troubled Eurozone nations' bonds.

This has pushed Germany into a double-bind. If Germany lets its weaker neighbors default on their sovereign debt, German banks will fail, but if Germany becomes the "lender of last resort," then the German taxpayers end up footing the bailout bill.

If public and private debt in the troubled nations keeps rising at current rates, it's possible that even mighty Germany may be unable (or unwilling) to fund an essentially endless bailout. That would create pressure within both Germany and the debtor nations to jettison the single currency as a good idea (in theory), but an ultimately unworkable one in a 17-nation bloc as diverse as the Eurozone.

Reason #3: Crushing Private and Public Debts

Banks around the world have a major challenge in the next few years: trillions of dollars in debt must be "rolled over" or refinanced. Globally, banks owe about $5 trillion to bondholders and other creditors that will come due by 2012, according to the Bank for International Settlements (BIS).

But European lenders have a substantial share of that burden: About half of the liabilities—some $2.6 trillion--are in Europe.

The BIS has several fundamental concerns about this stupendous Eurozone debt load. One is that banks desperate for refinancing will compete with governments such as those in Greece and Spain, which must also roll over gigantic sums in the global bond market. Competition for bondholders' favors will result in higher credit costs for business and consumers, with predictable consequences: Higher borrowing costs lead to reduced economic activity.

The BIS's second great concern is the gargantuan sums that have been promised to citizens in Eurozone social welfare programs. As Europe's working-age population shrinks and the number of its retirees rises, the ability of governments to pay the benefits and service the huge debts that have been accumulated is in question.

The choices facing governments with rising social welfare costs and debt costs are bleak. Either cut benefits or raise taxes on a dwindling base of workers--or both.

The bottom line: The flaws in the structure of the European Union and euro cannot be resolved by face-saving compromises and additional bailouts.

Since the devolution of the Eurozone and the euro is baked in, as investors we need to think through the consequences of a probably messy restructuring of the EU and the euro. In Part II of this report: Positioning Yourself for the Devolution of the Euro, we delve into the most probable series of outcomes for the euro and how investors can position themselves to protect and possibly increase the purchasing power of their capital vs. this troubled currency.

Wednesday, September 21, 2011

Beneath all the distractions of austerity and bailouts, the basic structure of the Eurozone is fatally flawed.

Europe’s fiscal and debt crises have dominated the financial news for months, and with good reason: the fate of the European Union and its common currency, the euro, hang in the balance. As the world’s largest trading bloc, Europe holds sway over the global economy: if it sinks into recession or devolves, it will drag the rest of the world with it.

As investors, we are not just observers, we are participants in the global economy, and what transpires in Europe will present risks and opportunities for investors around the world.

The issue boils down to this: is the European Union and the euro salvageable, or is it doomed for structural reasons? The flaws are now painfully apparent, but not necessarily well-understood.

The fear gripping Status Quo analysts and leaders is so strong that even discussing the euro’s demise is taboo, as if even acknowledging the possibility might spark a global loss of faith. As a result, few analysts are willing to acknowledge the fatal weaknesses built into the European Union and its single currency, the euro.

In the first part of this series, we’ll examine the structural flaws built into the euro, and in the second part, we’ll consider the investment consequences of its demise.

Fatal Flaw #1: Expanded Private Credit, Toothless Fiscal Discipline

We can start with the flaw that has been widely acknowledged: the asymmetry between the benefits of extending credit to member states and the lack of control over those states’ Central State fiscal budgets and structural deficits.

While the European Union consolidated power over the shared currency (euro) and trade, it did not extend control over the member states’ current-account (trade) deficits or budget deficits. While lip-service was paid to fiscal responsibility via a 3% cap on deficit spending, in the real world there were no meaningful E.U.-controlled limits on private or sovereign (central government) borrowing and spending.

In effect, the importing nations within the union (Ireland, Greece, Portugal, Spain and Italy) were awarded the solid credit ratings and expansive credit limits of their exporting cousins, Germany, The Netherlands and France. In a real-world analogy, it’s as if a sibling prone to paying life’s expenses with credit was handed a no-limit credit card with a low interest rate, backed by a guarantee from a sober, cash-rich and credit-averse brother/sister.

Rising Risk Leads to Rising Rates

Needless to say, it was highly profitable for the big European and international banks to expand lending to these new, previously marginal borrowers. This led to over-consumption by the importing States and staggering profits for big Eurozone banks. And while the real estate and credit bubble lasted, the citizens of the bubble economies enjoyed the consumerist paradise of borrow and spend today, and pay the debts tomorrow.

Tomorrow has arrived, but the foundation of the banks’ assets—for example, the market value of housing in Spain—has eroded to the point that both banks and homeowners are insolvent. The heightened risk of default, both by banks and the governments trying to bail them out, has caused interest rates in the debt-burdened countries to rise.

Faced with the rising costs of servicing their debt and deep cuts to government budgets, the citizenry of the profligate member states are rebelling against austerity measures. Meanwhile, taxpayers and voters in the exporting member states such as Finland and Germany are rebelling against the gargantuan costs of bailing out their weaker neighbors.

There is no way to resolve this asymmetry between credit expansion and sovereign fiscal imbalances without sacrificing national autonomy to E.U. bureaucrats, who would presumably gain authority over tax laws and collection in Greece, Italy, Spain, Portugal and Ireland.

To expect these states to surrender their autonomy for the dubious benefits of servicing their crushing debts to big European banks is an exercise in political fantasy: it isn’t going to happen.

Fatal Flaw #2: Profits Are Private, Losses Are Public

But beneath this one acknowledged structural imbalance lies even deeper flaws embedded in the model of Neoliberal Capitalism, the "liberalization" of trade and capital flows as a means of opening markets and enabling free enterprise to take on tasks formerly reserved for government (the Central State) or State-sanctioned corporations.

The key feature of the Neoliberal model borrowed from Classical Capitalism is that the risks of enterprise and the investing of capital are (supposedly) transferred from the Central State to the newly liberalized private sector. But this turns out to be a charade played out for public-relations/perception management purposes: when the expansion of credit and financialization ends (as it must) in the tears of asset bubbles popping and massive losses, then the Central State absorbs the losses which were supposedly private.

My definition of Neoliberal Capitalism differs significantly from the conventional view:markets are opened specifically to benefit the Central State and global corporations, and risk is masked by financialization and then ultimately passed onto the taxpayers. In this view, the essence of Neoliberal Capitalism is: profits are privatized but losses are socialized, i.e. passed on to the taxpayers via bailouts, sweetheart loans, State guarantees, the monetization of private losses as newly issued public debt, etc.

The Neoliberal model is superficially a win-win for both global corporations and Central States, as the Central State benefits from the explosion of tax revenues created by financialization and the expansion of credit, and from the swag showered on political apparatchiks by the global corporations.

From a Neoliberal perspective, the union consolidated power in a Central State proxy (The E.U.) and provided large State-approved cartels and quasi-monopolies access to new markets—the previously marginalized importing states.

From the point of view of the citizenry, it offered the benefit of breaking down barriers to employment in other Eurozone nations. On the face of it, it was a “win-win” structure for everyone, with the only downside being a sentimental loss of national currencies.

Thus the expansion of the united European economy via the classical Capitalist advantages of freely flowing capital and labor were piggy-backed on the expansion of credit and financialization enabled by the Neoliberal model of the union.

The alliance of the Central State and its intrinsic desire to manage the economy to benefit its fiefdoms and classical free-market Capitalism has always been uneasy. On the surface, the E.U. squared the circle, enabling stability, private-bank credit creation and easier access to new markets for all.

But the fatal flaw in the Neoliberal model has now been revealed: once the unlimited credit issued by financialization poisons the sovereign states’ balance sheets and cash flows, then there is no mechanism to bail out all the players: the “too big to fail” European banks, the sovereign debtor states and private-sector borrowers. All three are now hopelessly insolvent, and the conventional fixes of renegotiating the terms and extending additional credit are simply papering over this stark reality.

Fatal Flaw #3: Low Interest Credit Spurred Misallocation of Capital

The financialization unleashed by the E.U. had other poisonous consequences.

Credit at very low rates of interest is treated as “free money,” for that’s what it is in essence. Recipients of free money quickly become dependent on that flow of credit to pay their expenses, which magically rise in tandem with the access to free money. When access to free money is suddenly withdrawn as the borrower’s ability to service the debt comes into question, the debtor experiences the same painful withdrawal symptoms as a drug addict who goes cold turkey.

Other pernicious effects follow. Free money soon flows to malinvestments whose risks and marginal nature are masked by the asset bubble which inevitably results from massive quantities of free money seeking a speculative return. This systemic misallocation of capital is exemplified by the empty McMansions littering the countryside in Ireland and Spain.

The Neocolonial Model of Financial Exploitation

The E.U.’s implicit guarantee to make good any losses at the State-sanctioned large banks—the Eurozone’s “too big to fail” banks—enabled a financial exploitation that is best understood in a neocolonial model. In effect, the big Eurozone banks “colonized” member states such as Ireland, following a blueprint similar to the one which has long been deployed in developing countries.

This is a colonialism based on the financialization of the smaller economies to the benefit of the big banks and the member state governments, which realize huge increases in tax revenues as credit-based assets bubbles expand.

As with the Neoliberal Colonial Model (NCM) as practiced in the developing world, credit-poor economies are suddenly offered unlimited credit at very low interest rates. It is “an offer that’s too good to refuse” and the resultant explosion of private credit feeds what appears to be a “virtuous cycle” of rampant consumption and rapidly rising assets such as equities, land and housing.

Essential to the appeal of this colonialist model is the broad-based access to credit: everyone and his sister can suddenly afford to speculate in housing, stocks, commodities, etc., and to live a consumption-based lifestyle that was once the exclusive preserve of the upper class and State Elites (in developing nations, often the same group of people).

In the 19th century colonialist model, the immensely profitable consumables being marketed by global cartels were sugar (rum), tea, coffee and tobacco—all highly addictive, and all complementary: tea goes with sugar, and so on. (For more, please refer to Sidney Mintz’s book, Sweetness and Power.)

In the Neoliberal Colonial Model, the addictive substance is credit and the speculative consumerist fever it fosters.

In the E.U., the opportunities to exploit captive markets were even better than those found abroad, for the simple reason that the E.U. itself stood ready to guarantee there would be no messy expropriations of capital by local authorities who decided to throw off the yokes of European capital colonization.

The "too big to fail" Eurozone banks were offered a double bonanza by this implicit guarantee by the E.U. to make everything right: not only could they leverage to the hilt to fund housing and equities bubbles, but they could loan virtually unlimited sums to the weaker sovereign states or their proxies. This led to over-consumption by the importing States and staggering profits for the TBTF Eurozone banks.

Now the losses resulting from these excesses of rampant exploitation and colonization by the forces of financialization are being unmasked, and a blizzard of simulacrum reforms have been implemented, none of which address the underlying causes of this exploitive financialization.

The European Central Bank (ECB) and the E.U. political leadership are trying to stabilize an intrinsically unstable private-capital/State arrangement—profits are private but losses are public—by shoving the costs of the bad debt and rising interest rates onto the backs of taxpayers. The profits from this Neoliberal exploitation were private, but the costs are being borne by the taxpaying public.

In the insolvent states, taxpayers are seeing services cut and higher taxes/fees, while those in the mercantilist (exporting) economies are being saddled with higher taxes to fund the bank bailouts.

The useful fiction (useful to the banks and their apologists in office) is that it is the insolvent nations that are being bailed out, but in reality it is the big banks which loaned vast sums to these nations which are being bailed out.

In effect, the residents of the E.U. are being forced to bail out private banks. At some point, the citizens of one or another sovereign state will refuse, and the Union will break along the lines of those states committed to saving the banks and those which are willing to throw the banks under the bus as an act of self-preservation.

This entry is a reprint of "The Fatal Flaws in the Eurozone, and What They Mean For You" which I wrote for Chris Martenson.com as a contributing editor.

Tuesday, September 20, 2011

If all we've been doing for the past decade is borrowing money to support the friction in our economy, then any reduction in borrowing and/or energy will cause a sudden collapse/freeze-up as the forces of friction dominate.

A fascinating article on The Oil Drum website, The Seneca Effect, explains why systems can collapse rather than decline in symmetry with their gradual rise. This dynamic could be applied to a number of systems, including oil production and the entire oil-dependent global economy.

Correspondent David P. offered this insightful commentary on the explanatory power of friction. Friction is a concept we all understand: productive output/work is sapped by the friction of its moving parts. The greater the friction in the system, the less output. As friction rises, or the energy input declines, then at some point the system is unable to overcome the cumulative friction, and it freezes.

David's provocative idea is that much of our economy is in effect mere friction. If energy costs rise or supply (input) falls, then the system will freeze up/collapse.

RE: The Seneca Effect: There's something in there I can't quite frame. Let me try. Pollution isn't really pollution, its the slow build up of frictional force that siphons off energy. And the friction never goes away, its simply an ever-increasing tax that ends up dominating at the finale.

In the US, this takes the form of a massive bureaucracy, expensive regulation that favors big corporations, corruption, financial skimming, the military force of Empire, a nanny state -- all of the institutionalized waste that builds up slowly when times are good. Friction is easily overcome when energy is plentiful, times are good and so it is overlooked or tolerated. But when energy starts to deplete, that frictional force remains the same size, and so it has an oversized effect on the downside and hastens the collapse.

So where are we in the graph?

Borrowing and spending 10% of GDP resulting in being able to run at the same speed (flat GDP growth rate) would seem to indicate where we are. What comes next, I dare not imagine, but we all know that unsustainable things cannot continue forever. And I notice the vast majority of our national policy is spent keeping frictional forces securely in place.

The new bit of information for me is that the friction dominating the endgame results in a very steep descent.

Thank you, David, for presenting a profound concept/metaphor. If we ask what parts of the U.S. economy are essentially friction, we quickly come up with a substantial list:

1. Wall Street: a vast skimming operation on the productive elements of the economy

2. Interest: a hidden tax on productive work (as noted yesterday, on the Federal level, interest on the national debt can be seen as a criminal skimming enterprise)

3. The 40% of our healthcare/sickcare costs that are paper-shuffling, fraud, etc.

5. The National Security State/global Empire--huge buildings go up in D.C. by the dozens, all filled with unaccountable bureaucrats and contractors

6. Fiefdoms which have captured the machinery of governance: Junk fees and taxes skimmed to support unproductive layers of bureaucracy

7. Exurbia: the cost of driving out to the big box stores

You can add many more sources of friction to this list. The point made by David is sobering: in a system increasingly dominated by friction, the endgame descent can be much steeper than most participants believe possible.

Sunday, September 18, 2011

Is the Federal debt a criminal enterprise, enabled by a criminal syndicate? Read on before you pass judgment.

Correspondent Doug laid out a compelling case that the Federal debt is fundamnentally a criminal scam, operated by the criminal syndicate of the Treasury and the Federal Reserve:

The Federal Reserve is a criminal syndicate buying debt that the government eagerly creates and sells for spending money that dumps the debt on us civilians. What perplexes me is that the scam is so simple and all the intellectuals either don’t get it or are handcuffed by mega-corporate media owners.

4. The debt is breaking us; life will not be the same in the years to come

Uncle Sam borrows all its spending money from the non-government Fed and others, and spends only borrowed dollars raised from exchanging bonds for dollars as a debt plus interest on your back.

Uncle Sam collects income taxes and funnels the money to the holders of these criminal Treasury bonds.

The Fed/Treasury is an evil axis defunding you and me: the debt is $14.5 trillion; this is our debt, not the government’s debt. The government does not generally earn money; we do. Therefore every criminal debt certificate (Treasury bond) the Treasury exchanges for cash is a debt on you and me--a promise to pay for which citizens are responsible to pay, IOUs in simple terms. If the government printed the money instead of the criminal Fed, there would be no debt.

Uncle Sam borrows bucks and you become automatically indentured to pay back the bond and pay the vig! How is this not a criminal enterprise? If you go to a loan shark, at least you get to have the money in your hand and can spend it before you have to repay the loan and pay the vig!

Thank you, Doug, for explaining the criminal nature of the Federal Debt and the agencies and Fed that enable and enforce it. As we know, the Federal budget (and the "supplemental appropriations" that add hundreds of billions of dollars in "off-budget" spending) is consolidated. In other words, the government doesn't specify that taxes collected paid for X spending and that the remaining Y spending is paid by borrowing money via selling TReasury bonds, so what spending is "paid by debt" is a politically charged assessment.

What the ballooning debt actually funds depends on the political convictions and agenda of the commentator, along with what constitutes "waste" in Federal spending. Some attribute the Federal deficit/borrowing to Medicare, others to hot wars and the Military-Industrial Complex, and still others to the endless bail-outs of financial Elites.

The common-sense perspective is to compare the circa 2000-01 $2.1 trillion annual Federal budgets of the pre-Global War on Terror (GWOT) and multi-trillion dollar bail-outs of banks/financial Elites with today's $3.8 trillion annual budget (not counting all the political hot-potato spending hidden in "supplemental appropriations" to keep it out of the scrutinized budget). Since inflation was officially low for most of the decade, this vast increase in Federal spending cannot be explained as inflation; adjusted into real dollars (adjusted for inflation), it is still 40% pre-war, pre-bail-out levels.

Yes, Medicare spending is rising at 6%-7% annually, regardless of which political party is in power, and Social Security spending is outsripping the system's tax revenue income. But clearly, a National Security State with few if any meaningful restraints on its spending (no "anti-terrorist" dictatorship shall go unrewarded/unfunded, etc.) or influence has added trillions in spending with little oversight or accountability.

The same can be said of the endless trillions squandered bailing out the banks and related financial Elites, including the quasi-Federal agencies (Fannie Mae and Freddy Mac) that funded the criminal enterprise known as the housing bubble/bust.

If the majority of the additional Federal spending was in fact squandered to boost the revenues, earnings and political influence of Elites, fiefdoms and special interests, then the taxpaying citizenry footing the bill did not receive any measurable benefit from all this additional debt. As Doug observed, the taxpayers are in effect borrowing vast sums from the loan sharks and not even getting to spend the money on themselves: the money was squandered on Elites, supposedly on behalf of the taxpayers, who must pay interest (i.e. the vig, "vigorish") on the fast-rising debt.

Friday, September 16, 2011

Small business isn't hiring, and the reasons are invisible to those without any real-world small business experience.

Most of the discussions about boosting hiring and employment are detached from the realities faced by actual small-business employers. Pundits protected by ivory-tower tenure or plump think-tank positions can indulge in the luxury of debating the efficacy of modest tax cuts on hiring, but for those in the trenches of small business, these economic-policy debates are as germaine and valuable as debating how many angels can dance on the head of a pin.

The reality is that adding an employee is very costly and adds multiple layers of risk. Small business is not going to hire another employee because the employer's share of Social Security taxes is a few hundred dollars less. Adding an employee could, without exaggeration, cost the employer his business and/or his sanity. Think of someone in the ocean with a water-logged life preserver, someone whose head is barely above water. That is the typical small business employer: it won't take much to push him/her under.

Robert F., a small-business employer for 22 years, shares the rarely-addressed point of view of the employer:

I own a security firm in a major Western-U.S. city. I have been an employer for 22 years. What a nightmare it is! Few seem to understand why businesses don't want to hire--here's my perspective.

Once I hire someone, I am party to a relationship that is full of risk. What usually happens is the "check harvesting" situation where just enough work is done to extract a paycheck. I am on the hook for matching Social Security tax, medicare tax, city occupational tax, unemployment tax, federal unemployment tax, workers comp insurance and all the abuse that goes along with that system. I have to withold State and Federal income taxes with ridiculous penalties for late payments. Often I will get served with a garnishment or child support levy for an employee, and I am on the hook for all this. If I fail to withold on a garnishment I become liable to pay the debt.

To take one real-life example of many: after all this, the employee can't get along with others, grows a beard and says it's a religious right, needs weekends off because he goes to church and it's descriminatory for me not to give him time off for his beliefs.... soon I'm looking for a way to fire him. Now the rage begins! I am subject to violence, attacks, retribution, slander-- everything all because the employee won't/can't do the job he accepted.

I have been through terminations where I was threatened with a gun, had to call the cops, etc. The usual take is that the police will take action after the homicide spree is done with. My nice Chrysler car got a cinder block thrown throught the window a few years back (oh, but there's no proof it's the guy I fired one week ago who punched his fist throught the window and had the paramedics haul off out of my office.)

Sure, I've had some great employees too--people who I only have good things to say about. I also paid them every cent I owed them and they often got more than their base pay--bonuses, extras, etc. But I could write another two pages on malicious lawsuits. For example, I promote some guy and a woman is burned up because she didn't get it and "it's discrimination." One guy is gay and other employees tease-- my job to step in and mediate and manage the mess and "This is a hatefull workplace-I'm going to be talking to a lawyer."

If I advertise for a job opening, my office fills up with the angry, over-qualified, alcoholic dead-beats and weed smokers... they all have rights of course and I owe them a job. So, Obama says employers need to hire the uenmployed? Yeah, sure! Sorry if I sound bitter-- this is my last year doing this and then I am going solo/free-lance. While I might earn less, I will have my sanity!

Many non-employers will read this and dismiss it as hyperbole or atypical; those of us who have had burdensome payrolls know it is simply realistic. The issues of high costs and multiple risks are societal and cannot be reduced to econometric quantification; the burdens and entitlements built into the labor market are not fully revealed by statistics.

As someone who has experience as an employee, as an entrepreneur who ran a small business with dozen or more employees, and as someone who has spent decades as a self-employed free-lance contractor, I understand the compelling benefits of sole proprietorship in which all labor is subcontracted to other free-lancers/sole proprietors: the taxes, healthcare, insurance and all the rest are the responsibility of each free-lancer/contractor.

This arrangement places a premium on professional conduct: in this world, each sole proprietor agrees to do X work for Y compensation paid in Z timeframe. A focus on entitlement is of no interest to people expecting professional behavior and results. An "entitlement/employee" attitude will quickly alienate those who just need X work done in Y timeframe, and unprofessional work or conduct will result in a loss of future work.

The 1980s song proclaimed "take this job and shove it:" in this era, it's small business owners who are muttering, "take this business and shove it, I'm outta here."

While the dearth of small business hiring mystifies pundits and government officials, it's no mystery to me: I hear from small business owners all the time, and the vast majority are bailing out of their business and the travails of employees, taxes and legal hassles for retirement or a free-lance/contract mode of business.

In this world, security comes not from contractual obligations imposed on employers, but on the quality and professionalism of the work and behavior. Those who mourn the passing of the old era are free to start their own businesses and hire as many people as they want.

Email alert: As a result of family visits and obligations, I will be unable to respond to email for the next few weeks. Blog entries will likely be sporadic as well. Your understanding is greatly appreciated.

Fall Garden/Seed Special: Our friends at Everlasting Seeds have put together a Fall Garden Special on seeds: "George at UrbanSurvival suggested a new fall garden collection that would allow folks to extend their gardens, concentrating on the more hardy [and 'table substantial', in contrast to, say, herbs/seasonings], especially those with cold frames or greenhouses; this collection consists of 188 seeds per variety (click link below to view entire list). The price of this special offer, normally $88.00, is $80.00."

PRINT EDITION DISCOUNT: The print edition of An Unconventional Guide to Investing in Troubled Times is now available at a 31% "pre-release" discount for readers of oftwominds.com through the publisher, Createspace. (List price $25.85, discount price $17.85) You will have to set up an account with Createspace to order the book directly and receive the 31% discount. After you click "add to cart," insert this discount code M4A8ED8B in the "options and discount" section of the following page.

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